On a recent trip to China, I arrived with a cautious attitude only to leave with a renewed sense of comfort in the country’s long-term growth story. I also gained interesting insights into China’s influence on the global commodity markets.
From a macro perspective, there is no doubt that monetary tightening, higher commodity prices and electricity shortages are slowing China’s GDP growth. Credit tightening is having a serious impact on small and medium-sized companies, which will inevitably lead to more non-performing loans in the banking sector.
Automobile sales are weak due to government measures, housing sales are dropping and a weak domestic stock market points towards tightening liquidity. There is no question that China’s stimulus programs of 2009-10 led to some significant misallocation of capital and probably brought forward some commodity demand.
However, to my mind, all this suggests an engineered cyclical slowdown in the pace of growth, designed to control inflationary pressures, rather than signposts on a path to structural decline as some of the China bears would have you believe.
First, a few words on growth. HSBC recently published an interesting time line that put the development of various emerging markets into historical context by placing them on a timeline of US economic development.1 On this basis, China stands about where the US was in 1941. (Die-hard commodity bulls will notice that India is where the US was in 1882.)
However, what is even more interesting is that China is achieving in a decade what it took the US 50 years to achieve.
This rapid pace of innovation and productivity growth was apparent during my trip. For example, the Chinese have worked hard to increase the domestic supply of some resources and to bring down costs. In commodities like aluminium, bauxite, nickel and stainless steel, Chinese companies are innovating and are, in some cases, more competitive than western companies. In manufacturing, the significant size of the domestic market again gives Chinese companies a significant scale advantage, allowing them to invest more in R&D.
Property and consumption
Much has been written about the supposed property bubble in China. My view is slightly more nuanced than some of the recent commentary. It is true that property prices are towards the top end of their rising trend in real terms and the house-price-to-income ratio is high. The amount of floor space under construction has soared in the past decade and it is argued that prices need to drop to clear supply.
However, the strong counter-argument is that the total housing stock in China is still short of demand (according to some estimates, by almost 80 million units). Most of the supply has been at the top end and has been absorbed by investors paying cash (given a lack of other domestic investment alternatives in an era of negative real interest rates), leaving a real shortage in the middle and at the bottom end of the market. It is as if there has been massive over-building in Knightsbridge in London but too little construction outside the capital. The government, through its social housing initiative, is trying to set this imbalance right and, over time, this will support commodity demand.
Domestic consumption also remains a positive driver of demand for some commodities. Copper looks to be a beneficiary, thanks to its importance in, for example, air conditioning and car manufacturing. China remains committed to innovation and renewable technologies. New electric cars, for example, use up to three times as much copper as traditional ones. Cars are largely bought for cash in China and, with fewer than 60 cars per 1,000 people (compared with 750 in the US and an average of 150 in the world), the growth road stretches a long way into the future.
So, for me, the main insights from my recent trip were firstly that China remains on a structural growth path, even as it tries to navigate a near-term engineered cyclical slow-down to combat inflation.
The second was that innovation and productivity remain strong and, while rising labour inflation is a worry, increased GDP per capita will drive the economy more towards consumption-driven growth.
Thirdly, as China moves towards becoming a consumption-driven economy (as opposed to the investment-driven growth that it has experienced over the past 10 years), the outlook for consumption commodities (energy, platinum, potash, oil) will be superior to those driven primarily by investment spending (steel, aluminium, iron ore, etc).These changes will play to the strengths of stock pickers over the next 10 years.